Global Economic Outlook Q2 2012

A Deloitte Research publication | 2nd Quarter 2012
A Collective Sigh of Relief

Eurozone Could this be the turning point? United States Why the euphoria? United Kingdom The outlook brightens Japan New risk factors India A delicate balance Trade patterns of the future Waking up and smelling the coffee
Global Economic Outlook Q2 2012

Were several months into the year 2012, and things are beginning to look less dire than the last few months of 2011. In Europe, a second bailout of Greece has at least postponed disaster. Plus, action by the European Central Bank may have averted a deeper downturn. In the United States, growth continues at a modest pace, but signs of trouble have not completely gone away. And in China, the economy appears likely to avoid a hard landing. While there is no cause for celebration, business leaders can at least utter a collective sigh of relief that things are not worse. In this issue of the Global Economic Outlook, we take a close look at the factors driving the global economy. We begin with Dr. Alexander Brschs analysis of the Eurozone. The title of his article Could this be the turning point? draws attention to the fact that things are not as bad as some had predicted. He notes that four major decisions in Europe in recent months have improved the outlook, reduced the risk of catastrophe, and moderated the severity of the recession. In addition, Alexander takes a close look at what may be required in order for Greek membership in the Eurozone to be sustainable. Next, Carl Steidtmann maintains his relatively pessimistic stance on the U.S. economy. He says that some of the data points that appear to herald improvement are really rather ephemeral. For example, he notes that economic activity has been boosted by good weather, temporary tax incentives, and inventory rebuilding hardly the stuff of sustainable recoveries. He also points out some of the unintended consequences of the Feds monetary easing. Finally, while Carl acknowledges that modest growth can continue for some time, he cautions that there are many fat tail geopolitical risks that could pull the United States into another downturn. Also included in Carls article is an analysis of oil prices and their impact on economic activity. In our third article, I take a look at Chinas economic outlook. I discuss how Chinese government policy has been effective in partially offsetting the negative external headwinds faced by Chinas export sector. The result is likely to be a soft landing this year. However, China continues to face longer-term challenges, some of which are being pushed further down the road by the failure to address them in the short term. Next, Ian Stewart examines the UK and concludes that the economy is doing far better than earlier thought, but its performance in 2012 is still expected to be relatively poor. Ian examines the Deloitte UK CFO Survey and finds that business leaders have significantly improved their perceptions and expectations. This should have a tangible effect on economic activity. Ian also notes that a combination of easier monetary policy and the lessening of crisis in Europe will likely help the UK to avoid recession in 2012. Siddharth Ramalingam then provides his outlook for the Indian economy. He notes that the central bank is caught between a rock and a hard place. That is, the central bank must worry about uncomfortably high inflation as well as decelerating growth. In addition, a large fiscal deficit means that the government has few policy options to deal with a dete-
riorating situation. Siddharth concludes that an easing of monetary policy will likely be the eventual outcome. My outlook for Japan begins by discussing problems related to Japans trade balance, fiscal policy, and currency. Given these issues, it would seem natural to expect economic weakness. Yet I conclude that things will likely get better in 2012 for several reasons: a more aggressive monetary policy, a weaker yen, higher inflation, and more government spending on reconstruction. In the outlook for Brazil, I note that although Brazil has experienced a deceleration, growth is expected to rebound later this year. A loosening of monetary policy and a boost to investment in infrastructure and energy should help to offset the negative external headwinds. I also discuss Brazils complaints about the impact of U.S. and EU monetary policy on the Brazilian exchange rate as well as global concerns about Brazils protectionist policy initiatives. In my outlook on the Russian economy, I note that there are several conflicting factors influencing growth in Russia, and that the economy in 2012 is likely to grow more slowly than in 2011. I also discuss the uncertainty surrounding the future of Russian economic policy and how the choices made by policymakers will determine future growth.
Next, Pralhad Burli offers a view on the economy of Indonesia, the worlds fourth most populous nation and one that has lately attracted much attention for its strong growth and positive prospects. Pralhad discusses the resilience of this interesting economy and how, despite a variety of obstacles, it is likely to see strong growth in the coming years. Finally, Neha Jain and Satish Raghavendran look at global trade patterns. They note how, with rising wages and a rising currency in China, the worlds most populous nation may no longer be the worlds factory. Rather, global trade patterns are changing in interesting ways. Of most interest is the rising role of Africa and the Middle East in global trade.
Dr. Ira Kalish Director of Global Economics Deloitte Research
Global Economic Outlook published quarterly by Deloitte Research Editor-in-chief Ira Kalish Managing editor Ryan Alvanos Contributors Pralhad Burli Alexander Brsch Neha Jain Satish Raghavendran Siddharth Ramalingam Carl Steidtmann Ian Stewart Editorial address 350 South Grand Street Los Angeles, CA 90013 Tel: +1 213 688 4765 ikalish@deloitte.com
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Global Economic Outlook 2nd Quarter 2012
Contents
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Geographies
Eurozone: Could this be the turning point? In recent months, four major decisions in Europe have improved the outlook, reduced the risk of catastrophe, and likely moderated the severity of the recession. After restructuring Greeces sovereign debt, Europe will need to pursue structural reforms to stimulate growth. United States: Why the euphoria? Recent data that appears to herald economic improvement is anything but the stuff of sustainable recoveries. While modest growth may continue for some time, myriad geopolitical risks threaten to pull the United States into another downturn. China: Soft landing now, uncertainty later Recent policy decisions have been effective in partially offsetting negative external headwinds faced by Chinas export sector. The result is likely to be a soft landing this year. However, China continues to face longer-term challenges. United Kingdom: The outlook brightens The UK economy is exceeding previous expectations, but its performance in 2012 is likely to be relatively poor. A combination of easier monetary policy and the lessening of crisis in Europe will likely help the UK to avoid recession in 2012. India: A delicate balance Indias central bank continues its efforts to strike a balance between growth and inflation. Its large fiscal deficit means that the government has fewer policy options to deal with a deteriorating economic situation. Japan: New risk factors Problems pertaining to trade balance, fiscal policy, and currency would suggest economic weakness in Japan, but the countrys economic performance is likely to improve in 2012 because of a more aggressive monetary policy, a weaker yen, higher inflation, and more government spending on reconstruction.
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20 22
26 30
32
34
36
40
32 34 36
Brazil: Worried about capital inflows Brazil experienced a deceleration, but growth is expected to rebound later this year. A loosening of monetary policy and a boost to investment in infrastructure and energy should help to offset the negative external headwinds. Russia: Conflicting influences Several conflicting factors in Russia may result in slower growth in 2012. The countrys growth prospects will hinge on choices made by Russian policymakers. Indonesia: Unlocking potential Indonesias performance has been nothing short of stellar, and despite a variety of obstacles, there are plenty of reasons to be excited about Indonesias prospects in the coming year.
Special Topic
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Trade patterns of the future: Waking up and smelling the coffee With rising wages and a rising currency in China, the worlds most populous nation may no longer be the worlds factory. Rather, global trade patterns are changing in interesting ways.
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Appendix Charts and tables: GDP growth rates, inflation rates, major currencies vs. the U.S. dollar, yield curves, composite median GDP forecasts, composite median currency forecasts, OECD composite leading indicators
Dr. Alexander Brsch is Head of Research, Deloitte Germany
Eurozone: Could this be the turning point?

EUROZONE
by Dr. Alexander Brsch
After a turbulent 2011, the first months of 2012 were comparatively promising for the Eurozone. The downward cycle of fragile financial markets, vulnerable banks, a slowing real economy, and weak sovereign debtors is subsiding. Optimists consider this a turning point in the Eurozones crisis, but it could prove to be little more than a lull in ongoing economic instability. Several recent developments are kindling cautious optimism. The risk of a chaotic default by Greece seems to have faded. Bond yields of countries in the Eurozones periphery fell substantially, while Italy and Spain the two large countries that have experienced significant financial market pressures are introducing substantial economic reforms. On top of that, early indicators suggest that the Euro area is experiencing only a mild recession. This rosier outlook of the Eurozone was supported by four decisions that
Decision 1. Injecting liquidity into the markets The European Central Bank (ECB) completed the second tranche of its longer-term refinancing operation in late February. Bank borrowing in the first and second tranches amounted to more than 1 trillion and has been set for an exceptionally long period (three years) at 1 percent against a wide array of collateral. More than 800 banks participated in the February tranche. This is, by far, the biggest injection of liquidity in the history of the ECB. It helped ease pressure on the Eurozones banking sector and sovereign debt markets as banks used part of the new liquidity to buy sovereign bonds. The yields on Spanish and Italian 10-year government bonds fell below 5 percent in March from around 7 percent in December. However, in
helped reassure markets; most of these decisions are unprecedented in European economic history, illustrating just how desperate the crisis was.
Eurozone
Geographies
Figure 1. Use of ECB's deposit facility (EUR millions)
900,000.00 Deposit facility 800,000.00
700,000.00
600,000.00
500,000.00
400,000.00
300,000.00
200,000.00
100,000.00 0.00 11/14/07 6/1/08 12/18/08 7/6/09 1/22/10 8/10/10 2/26/11 9/14/11 4/1/12
Source: European Central Bank
mid-March, yields started to rise again. In mid-April, Italian bond yields stood at 5.5 percent, and Spanish yields stood at 5.9 percent. While injecting massive amounts of additional liquidity was at least temporarily successful in reassuring markets and helping buttress asset prices, it is no panacea for the European crisis. First, it increases medium-term inflation risks. Second, the new liquidity has not succeeded in restoring the operability of European interbank markets. One key
indicator for tension on interbank markets is the ECBs deposit facility, which Eurozone banks use in normal times to park excess cash overnight at low interest rates. Banks dramatically increased their use of this facility during the recent crises. In mid-March, the volume stood at 750 billion, almost 50 times more than a year ago (see figure 1). The fact that banks prefer the safety of an ECB deposit over higher margins on the interbank market suggests that the uncertainties plaguing the European banking and financial systems are lingering.
In the short term, growth prospects for the Eurozone look better than many feared in the beginning of the year when a severe recession was widely expected.
Decision 2. Signing the fiscal compact The treaty on stability, coordination, and governance the fiscal compact was signed by 25 of the 27 EU leaders as an intergovernmental agreement; the United Kingdom and the Czech Republic did not join. The key point of the treaty is a balanced budget rule, which mandates that annual structural budget deficits cannot exceed 0.5 percent of GDP. The rule must be incorporated into national law, preferably at the constitutional level. The EU Court of Justice will oversee the rules transposition and will have the power to impose severe sanctions. Promoted by Germany and other northern European governments, the rule is supposed to prevent unsustainable future government debt. The fiscal compact is intended to significantly constrain government spending in the future. Whether or not it will solidify public finances will depend on its implementation and therefore on politics at both the national and European levels. Decision 3. Restructuring Greek private debt Finally realizing that it has taken on more debt than it can realistically ever expect to pay back, Greece undertook the biggest sovereign-debt restructuring in history. It is the first time in six decades that a developed country has defaulted on its debt. Technically, private investors will receive new government bonds with long maturities, which amount to a loss of 53.5 percent. Some 86 percent of Greeces private debtors agreed to participate in the 206 billion bond swap. Through the use of collective action clauses, the government will force reluctant investors who own bonds to participate in the swap under Greek law. The program decreases Greek debt by 100 billion. As a result, Greek debt currently 164 percent of GDP is supposed to stand at 120 percent of GDP by 2020. After the successful swap, the European Union agreed to a second bailout package, which amounts to 130 billion in credits until 2014. While the acceptance of the bond swap by private investors averted the threat of an uncontrolled default, two uncertainties remain. The first is whether the goal of a 120 percent debt-to-GDP ratio can be achieved. Given that the Greek economy is shrinking far more than expected,
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this is questionable. The second is that 120 percent of GDP still amounts to an enormous mountain of debt, and there are many doubts that the Greek economy will be able kickstart itself again while laboring under this burden. Decision 4. Reforming Italy and Spain Meanwhile, Italy and Spain two large Eurozone economies that were endangered last year are introducing substantial economic reforms. The Italian technocratic government, headed by Mario Monti, redesigned Italys pension system, increased the retirement age, and is opening sheltered sectors. The government also plans to liberalize employment protection. Spains new conservative government is reforming its labor market by introducing greater flexibility in a system that is characterized by a two-tier structure. Older employees with unlimited contracts enjoy a high degree of protection, while younger employees tend to be on limited contracts. This is one of the key factors contributing to the huge social problem of the youth unemployment rate in Spain, which now stands at an unprecedented 51 percent. This fact raises the question of whether or not these austerity programs are sustainable in a political sense. The programs introduce short-term pain for large parts of the population while promising gains mainly in the long term. This could lead to a circle of austerity fatigue in the population, lobby group pressure, and protests, which can become an explosive combination. Radical parties opposed to austerity and reform policies might become stronger in elections, along with an increasing appetite for change in government. Since the beginning of the Euro crisis, governments have changed with remarkable frequency. Examples include Greece, Italy, Ireland, Portugal, and Spain. So far, changes in government have not worked against the reform programs. Nevertheless, the implementation of reform programs faces serious political risks. The short-term outlook is two-tiered In the short term, growth prospects for the Eurozone look better than many feared in the beginning of the year when a severe recession was widely expected. Looking back, the Eurozone as a whole achieved a growth rate of
Eurozone
Geographies
Figure 2. Economic Sentiment Indicator
120 100 80 60 40 20 0 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12

Source: European Commission
Germany France Euro area Spain Italy Greece
1.4 percent in 2011. In the last quarter of 2011, it experienced a negative growth of 0.3 percent. The European Commission expects a negative growth rate of 0.3 percent for the Eurozone in 2012, with a recovery of growth in the second half of the year. Current expectations, measured by the Economic Sentiment Indicator (ESI), are moderately optimistic. Economic sentiment is still considerably below its long-term average of 100, but it is recovering nonetheless (see figure 2). The ESI rose for a second consecutive month in February to 94.5, before decreasing by a marginal 0.1 points in March. Beneath the surface, however, developments point to deepening growth differentials in the Eurozone. While Germanys ESI stands at 104, the expectations for troubled Eurozone economies are still grim. Spains ESI is 91, Italys is 89, and Greeces is 76. Germanys situation is mirrored in the results of Deloitte Germanys first CFO survey. German CFOs feel that macroeconomic and financial market uncertainty is unusually high. They are also highly doubtful about the current and
future stability of the Eurozone as well as the effectiveness of the Eurozones political crisis management. However, they show moderate optimism when it comes to their own business outlooks. Growth differentials and two-tiered economic performance are dangerous because they reinforce the substantial difference in competitiveness between Eurozone nations. While the European Monetary Union was meant to lead to convergence in economic performance, the reverse has actually occurred, and economic performance and expectations continue to diverge. Neither growth patterns nor unit labor costs, one of the main indicators for competitiveness, have shown convergence in the Eurozone in the last decade (see figures 3 and 4). Greece: Too much debt, not enough growth Until a few years ago, Greece was one of the fastestgrowing European economies. From 2001 to 2007, its GDP grew on average by 4.1 percent per year. The Eurozone as a whole grew by 2 percent, and Germany grew by only 1.4 percent. As it turned out, after the financial crisis, this
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Figure 3. Unit labor cost index (2000 = 100)
140 135 130 125 120 115 110 105 100 95 90 2000
Source: OECD Figure 4. Annual GDP growth (% change year on year)
Greece Italy Spain France Euro area
Germany
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
8 6 4 2 0 -2 -4 -6 -8 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Germany France Euro area Spain
Italy
Greece
Source: Eurostat
growth performance was overwhelmingly based on high consumer and government spending, which resulted in the current debt spiral. Greece currently exemplifies two of the Eurozones key problems, even if it is the by far the most extreme case: too much debt and not enough growth. For 2012, Greece faces the prospect of a fifth consecutive year of negative growth. Last year, the Greek economy shrank by almost 7 percent. The debt restructuring and the second EU bailout package bought time for Greece and the Eurozone as a whole by averting the threat of a disorderly Greek default, at least in the short run. However, this is not a solution in itself. Without addressing its economys underlying
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problems and introducing structural growth policies, Greece will continue to have a bleak long-term outlook. Greece has a structurally weak economic base, which spills over to its creditworthiness on the financial markets. Investors need to be convinced that the Greek economy can generate resources to repay its debts in the future. Even achieving a debt-to-GDP ratio of 120 percent by 2020 requires substantial growth and primary budget surpluses. Greece needs to tackle both components of its debt-to-GDP ratio. Restoring Greek competitiveness Any new Greek government entering office after the coming elections needs to tackle the economic structures hindering growth and competitiveness. After all, economic
Eurozone
Geographies
competitiveness is based on productivity, and economic policy can contribute to growing productivity by fostering the business environment. Looking at the structures of the Greek economy and its business environment, two characteristics are particularly noteworthy: Economic structure: The structure of the Greek economy is different from the average EU country. For example, the share of agriculture is high, and the share of manufacturing low. What manufacturing industry exists is biased toward the production of food and basic goods, such as wood processing or paper production for local markets. The average size of Greek enterprises is exceptionally small, which implies lower productivity. Tourism is the main pillar of Greeces economic structure; it is slightly more important for the economy than manufacturing. Economic openness: As a rule, smaller European countries tend to have a high export ratio. Greece is an exception. In fact, Greece has the lowest export ratio of all EU countries. Greeces exports of services are focused on tourism and transportation, especially shipping, while comparative advantages in tradable goods are hard to detect. It even runs a trade deficit in food products. Manufacturing exports primarily consist of low-technology products. Greeces economic structure and openness imply that Greek firms have little engagement in global competition, resulting in negative consequences for productivity. Key indicators on how conducive the Greek business environment is for growth and productivity are not encouraging. Regarding corruption, in Transparency Internationals Corruption Perceptions Index, Greece ranked 80 out of 182 countries. In the World Banks Ease of Doing Business Ranking, which measures how business-friendly the economic environment is, Greece ranked 100. Its labor markets are highly regulated and so are its product markets. In fact, according to the OECD, it is among the most highly regulated product markets in the OECD world. Growth and structural reforms The status quo of the Greek economy implies that restoring competitiveness needs to include more than cost competitiveness. A new growth model needs to go beyond the important questions of prices, costs, and wages. It should consider Greeces advantages as well as the areas it should develop. There is a strong need to substantially improve business conditions and modernize the Greek economy, thereby boosting productivity. Improving productivity is a long-term project that involves structural reform on many levels. Some policies for
example, upgrading systems for education and innovation are crucial, but these improvements will mainly bear fruit in the long term. Other structural reforms, like labor market reforms, may have substantial transition costs. However, some structural reforms have positive short- and long-term effects. Reforming product markets is one main example. It can improve the functioning of markets by removing barriers for services and entrepreneurship. Such reforms tend to be associated with boosting long-term productivity and labor utilization as well as with positive employment gains in the short run. This goes especially for labor-intensive sectors with pent-up demand such as retail, trade, and professional services. Stimulating growth by removing entry barriers and product-market restrictions, especially in services, is not only relevant for Greece but for the European Union as a whole. The internal market has
been a great success story over the last 20 years. A further deepening, especially in the area of services, promises substantial economic benefits. With short-term fiscal stimulus becoming extremely difficult under Europes current fiscal situation, growth needs to come from structural reforms. The future of the Eurozone depends not solely on the financial markets but at least as much on the real economy and its future growth performance.
References and Research Sources: European Commission, Interim Forecast February, Directorate General for Economic and Financial Affairs, 2012. Karl Brenke, Greek Economy Needs Growth Strategy, DIW Wochenbericht, German Institute for Economic Research, 2012. OECD, Going for Growth, 2012. 11
Dr. Carl Steidtmann is Chief Economist at Deloitte Research
USA
United States: Why the euphoria?

by Dr. Carl Steidtmann
The stock market has forecasted nine of the past five recessions.
Paul Samuelson
The opposite is equally true; the stock market has also forecasted nine of the past five recoveries. The S&P 500 hit its all-time high in March 2000 at 1,527. The economy fell into a recession a year later. Growth since then has been less than spectacular, and total employment is no higher today than it was in 1999. The index managed to briefly break above its old high in mid-October 2007, only to slip into a deep recession that started in December. At its current level, the S&P 500 is still below its old highs set 4 and 12 years ago. The tech-heavy NASDAQs performance has been even worse.
The stock market has been partying like its 1999. We have seen an impressive rally since the lows of October 2011. But then we saw an impressive rally in the previous year, which was followed by less-than-impressive GDP growth in the United States and contracting growth in no less than 22 countries around the world in the fourth quarter of 2011, including Japan, Germany, and the United Kingdom respectively the third-, fourth-, and sixth-largest economies in the world. So, why the euphoria?
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USA
Geographies
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Figure 1. Growth in central-bank balance sheets from January 2007 to February 2012 (Percentage change)
250% 200% 150% 100% 50% 0%
2007 - present
Last 12 months
Central banks are pumping liquidity Quantitative easing (QE) is not just for the U.S. Federal Reserve. Around the world, we have seen unprecedented efforts by all of the major central banks to buy assets, expand their balance sheets, flood the banking system with liquidity, depress interest rates, and give a boost to asset prices (see figure 1). In the past six months, the biggest contributor to global liquidity unquestionably has been the European Central Bank (ECB), whose two-tranche 1.02 trillion Long-Term Refinance Operation (LTRO) program has expanded its balance sheet by 50 percent and taken fears of potential European bank failures due to a lack of liquidity out of the markets. Since mid-December, the actions of the ECB have sent equity prices up and the interest rates on sovereign bonds down. They also had a positive impact on commodity prices, with copper and oil prices up 20 percent while wheat, soybeans, and corn have risen more than 10 percent. It was the rise in commodity prices in spring 2011 that contributed to the Arab Spring protests throughout the Middle East and did so much to undermine real growth in the rest of the world in the summer and fall of 2011. While the ECB has been re-liquefying the European banking sector, the U.S. Federal Reserve has been engaged in Operation Twist, a very successful effort to drive down long-term interest rates by shifting Fed bond purchases from the short end of the Treasury curve to the long end. The effects of that policy, which went into effect last fall, can be seen in figure 2. Interest rates and stock markets tend to move in the same direction. A rising stock market is generally accompanied by rising rates as money flows from bonds into stocks. That has not been the case over the past six months. As the stock market has risen, longer-term interest rates have fallen. Rates on the U.S. Treasurys 10-year note are roughly 200 basis points below the level based on their historical relationship. While some might see this as the best of all possible worlds, the Feds efforts to keep interest rates depressed have unintended consequences.
ECB
U.K
China
Japan
U.S.
Swiss
Source: European Central Bank, Bank of England, Peoples Bank of China, Bank of Japan, U.S. Federal Reserve, and Swiss National Bank
Figure 2. The S&P 500 and 10-year Treasury yield Daily data
10-year Treasury yield 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0
2007-Sept 2011 Linear (2007-Sept 2011) Oct 2011 - March 2012 Linear (Oct 2011 - March 2012)
1.5 600 700 800 900 1,000 1,100 1,200 1,300 1,400 1,500 S&P 500 daily closing price
Source: European Central Bank, Bank of England, Peoples Bank of China, Bank of Japan, U.S. Federal Reserve, and Swiss National Bank
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USA
Geographies
Figure 3. Average price of regular gasoline all formulations adjusted for dollar weakness and ination ($ per gallon)
4.50 4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 $0.00 2001 2003 2005 2007 2009 2011 Price adjusted for dollar weakness Price adjusted for dollar weakness and ination Price of gasoline
Source: Energy Information Administration, St. Louis Federal Reserve
QE works by raising equity prices, lowering interest rates, and reducing the value of a countrys currency. Higher equity prices create a wealth effect, inducing consumers to spend more and businesses to increase investment. Lower interest rates reduce the cost of borrowing, encouraging consumers to purchase big-ticket items like cars and houses and businesses to take more risk. Finally, a lower exchange rate gives a boost to exports while encouraging consumers and businesses to buy domestic as opposed to more expensive imported products. Unintended consequences The problem with QE is that it has unintended consequences that offset its intended positive effects. A falling dollar does more than just give a boost to exports. It also gives a boost to the price of globally traded commodities in this case, oil. Oil prices rose sharply in spring 2011, following QE2 in the United States. They are rising again following Operation Twist and the ECBs LTRO. In the United States, gasoline prices are pushing $4 a gallon (see figure 3). In Europe, where energy taxes are much higher, gasoline prices are approaching $10 a gallon.
Oil prices when adjusted for changes in the consumer price index and the declining value of the dollar started rising only three months ago, and they increased only modestly in the last decade. Second, while low interest rates are great for both consumer and business borrowers, they represent a significant challenge for savers and pension funds. Businesses with defined benefit pension funds have to put more funds aside to fund these benefits when interest rates are low. Likewise, savers and retirees receive significantly less income from interest payments when interest rates fall. Interest income in the United States has fallen $447 billion or 31.5 percent since its peak in August 2008, just before the first round of QE. Risk-averse retirees are being forced to take on more risk in order to fund their own retirements. The most worrisome aspect of QE is that it enables businesses, consumers, and governments to take on more debt and risk when the problem that the economy is trying to come to grips with is an excess of debt. Low interest rates
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If debt cannot be reduced through the process of deleveraging, the only other alternative is a reduction of the debt burden through inflation.
encourage leverage and put off the adjustment process of deleveraging, distorting the economy and making the eventual day of reckoning all the more severe. Debt declined slightly during 2008 and 2009 (see figure 4). The decline was due largely to the sizable reduction in mortgage debt that has come about through the foreclosure process. Banks have also been forced to reduce debt through a tightening of the regulatory process. Nonfinancial businesses have seen their debt grow modestly, and government debt growth has risen sharply. Over the past year, total debt has increased by $781 billion. Nominal GDP grew by just $566 billion. Debt is still being accumulated faster than GDP is growing.
Figure 4. U.S. total debt (In trillions of dollars)
Curb your enthusiasm: Just the facts The disconnect between equity markets and the real economy can be seen in myriad different statistics. Here are the most troubling of them: 1. Globally, real GDP growth contracted in no less than 22 countries in Q4 2011, including Japan, Germany, Italy, Spain, the United Kingdom, Thailand, Singapore, Taiwan, Indonesia, and Portugal. Purchasing managers indices throughout Europe in the first quarter of 2012 show the decline continuing and deepening. 2. In the United States, employment growth is mainly in lower-paying jobs and temporary employment. The economy still has 5.3 million fewer jobs than when the recession started in December 2007. 3. The primary target of quantitative easing in the United States was housing. It was hoped that lower mortgage rates would stimulate borrowing. In mid-March, the Mortgage Bankers Associations index for new mortgage applications had declined eight weeks in a row. 4. Despite unseasonably warm weather across the United States in February, which should have boosted housing activity, new home sales fell 1.6 percent, existing home sales fell 0.8 percent, pending sales of existing homes fell 0.5 percent, and housing starts fell 1.1 percent. It is difficult for the economy in the United States to recover without a recovery in housing. A robust housing market gives a lift to new home construction, real estate, financial services, and retail. 5. In addition to a decline in home sales, home prices are also falling. Despite multiple predictions that housing has finally started to recover, home prices continue to fall. The most recent Case-Shiller Home Price Index was down 3.8 percent from a year ago and remains at its lowest level since the peak in home prices in March 2007. 6. Business investment in information technology has been weak. New orders for computers and related
55.0
50.0
45.0
$40.0 2006
2007
2008
2009
2010
2011
Source: U.S. Federal Reserve
If debt cannot be reduced through the process of deleveraging, the only other alternative is a reduction of the debt burden through inflation. The rise of debt over the past year greatly increases the future risk of much higher inflation.
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USA
Geographies
Figure 5. Equally weighted coincidental indicator (Percentage change year-over-year)
10 8 6 4 2 0 -2 -4 -6 -8 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Source: Bureau of Economic Analysis, Department of Labor, Bureau of Census and Federal Reserve
equipment were down three of the past four months from October to February, for a total decline of 14.9 percent. Shipments fell just 12.8 percent as the backlog of unfilled orders contracted. 7. U.S. energy consumption is declining sharply. Gasoline supplied to retail outlets is down 6.7 percent from a year ago in March. Oil consumption is down 4.5 percent. These are the largest year-over-year declines in more than 20 years, exceeding the declines that occurred during the 20072009 recession. 8. Shipping is showing multiple signs of distress. Trucking and rail indexes are both declining. The American Trucking Associations truck tonnage index was down 4.1 percent in February from its reading in December. North American railcar loadings for the month of February were down 2.9 percent compared to January and down 1.9 percent from a year ago. The Baltic Dry Index, a measure of global shipping rates, collapsed from October to February, dropping from 2,173 to 647 before rebounding in recent weeks to a stilldepressed 908. As recently as June 2010, the index was above 3,800. 9. Income from interest payments is again declining. Operation Twist, which was designed to depress long-term interest rates in hopes of stimulating housing, has had an ill effect on interest income. While housing continues to flounder, interest income has been declining. After a very
brief recovery in 2011, in January, interest income was down 2.8 percent from a year ago. 10. Federal tax revenues are slumping. Over the past three months ending in February, revenues are up just 0.6 percent from a year ago when revenues were depressed by the initiation of the temporary Social Security tax cut, which was extended through this year. 11. Real income excluding government welfare payments is still down 3.9 percent from its 2008 peak. Government transfer payments now account for 19.5 percent of all household income. Real disposable income was up just 0.5 percent in January. Real disposable income including transfers is up just 0.5 percent from a year ago. Where we are: Coincidental indicators Since the end of World War II, there have been 14 cases where real GDP growth from the previous year fell below 2 percent. In 11 of those cases, a recession followed. You can build a coincidental indicator of the economy using real disposable income, employment industrial production, and real consumer spending, and you get largely the same picture. Over the past 50 years, when this coincidental indicator fell below 2 percent for more than two consecutive months, a recession followed (see figure 5). The indicator has correctly anticipated all eight post-1960 recessions, including the
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recessions of 1960, 1969, 1973, 1979, 1981, 1990, 2000, and 2007. In 1986, the indicator fell below 2 percent for three nonconsecutive months as the collapse in oil prices took its toll on the oil-producing regions of the country. In December 1995, the sharp fall in real income sent the indicator just below 2 percent. In December 1994, Microsoft issued a massive one-time dividend that sent incomes up in 1994 and down on a percentage basis in 1995. The recent performance of the indicator has not been encouraging. Three of the four components of the indicator (income, spending, and production) are decelerating. The indicator has been below 2 percent for eight of the past nine months. There has never been a previous time when the indicator has performed in such a manner and a recession has not followed. Conclusions and observations: Its the dismal science, after all It was Thomas Carlyle who labeled economics the dismal science after reading Reverend Thomas Malthus. The business cycle remains alive and well. The current cycle has grown long in the tooth despite its young age. The U.S. economy has struggled over the past nine months, despite a soaring equity market. Growth has been given a boost by inventory building, tax incentives that shifted activity
from late 2011 to early 2012, and unseasonably warm weather. These are not the foundations upon which to build a recovery. Central banks around the world have been engaged in aggressive quantitative easing for more than three years now. There are limits to QE that are determined by its own set of unintended consequences. QE distorts market prices. The most obvious of these is the price of oil. Last spring, rising oil prices offset the positive effects of the Feds QE2 and left the economy with weak growth and rising inflation. This spring, we once again have a rising stock market and hopes of a stronger economy, this time as a result of the European Central Banks first round of QE, only to run into the same problem of rising energy prices. The U.S. economy very well may be able to muddle along for another year or two with subpar growth and rising inflation. The risk, however, is from one of the many fat-tail geopolitical risks, including a reemergence of the European debt crisis, a harder-than-expected economic landing in China, or a disruption of oil from Iran or elsewhere. With inflation rising and so little margin for error, there seems little reason for euphoria in the equity markets or elsewhere.
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USA
Geographies
Energy prices and consumer behavior

Wars are fought over it. Business cycles rise and fall around it. Political elections are won or lost because of it. There are few prices in the world that have a bigger impact on individuals, businesses, and even governments than the price of oil. After falling steadily since the spring of 2011, the price of oil reversed course in late December and has risen sharply. The increase has been all the more surprising given the unseasonably mild winter much of the United States is experiencing. Warm winter weather traditionally puts downward pressure on energy prices because demand for heating falls as the temperatures rise. The spot price of West Texas Crude rose from $93 a barrel to $110 between mid-December and early March. Prices for Brent Crude in Europe went from $102 a barrel to $126 over the same period of time. Rising oil prices have taken the price of gasoline at the pump higher by more than 50 cents a gallon in the United States. Oil consumption began declining in April 2011 when oil prices peaked and has accelerated over the past year even as prices declined in the latter half of 2011. As of March 2012, oil consumption was down 4.5 percent from a year ago (see figure 6). Drops of this magnitude usually have been associated with recessions. The decline in oil consumption could be due to a number of factors. Energy productivity traditionally rises in the face of rising prices and continues to rise for several years following a price spike. Warmer winter temperatures are also holding down consumption of heating oil, contributing to some of the decline. The biggest decline, however, has come in gasoline. Gasoline is both economically and politically important. It is a commodity that most households purchase on a regular basis. It directly affects consumer confidence and approval of current political leadership even though that political leadership generally has very little to do with the actual price. It can also have a signficant impact on consumer behavior. Every penny increase in the price of gasoline costs U.S. consumers an extra $3.8 million a day. An increase of 50 cents a gallon translates to $190 million a day, $5.7 billion a month, and $68.4 billion a year. In January, household income, after adjustment for taxes and inflation, was up just $60 billion from a year ago. Higher prices for gasoline are showing up in two places: lower gasoline consumption and fewer miles driven. Gasoline consumption is down 6.7 percent from a year ago on a threemonth moving average basis, an even greater drop than the demand for oil (see figure 7). The drop is even more surprising given the severity of last winter when compared to this years mild weather. Milder weather should have prompted more driving. The drop in gasoline consumption represents a combination of improved energy efficiency coupled with a significant decline in driving. Total miles driven on a 12-month moving average basis fell 1.2 percent in 2011 from a year ago (see figure 8). Over the past 40 years, there have only been three periods of time when the number of miles driven declined. All three were associated with deep recessions and sharply higher gasoline prices. While high gasoline prices limit driving, there are several others at work as well. Internet shopping continues to climb, taking share away from store purchases and reducing the number of shopping trips. Telecommuting has become a much more common practice and probably accounts for some of the decline as well. Rising energy prices have been a major factor in six of the past seven recessions since the first major oil price spike back in 19731974. Improved energy productivity, higher gas mileage, and greater use of the Internet for both shopping and work has reduced but not eliminated the exposure of the U.S. economy to current and future rises in the price of oil. As was the case in the spring of 2011, the United States and the global economy are once more at risk from rising energy prices.
Figure 6. U.S. petroleum products supplied Three-month moving average, year-on-year change through March 2012
15 12 9 6 3 0 -3 -6 -9 -12 1970 1975 1980 1985 1990 1995 2000 2005 2010
Source: U.S. Energy Information Administration Figure 7. Gasoline supplies delivered 13-week moving average, year-on-year change through March 2012
Source: U.S. Energy Information Administration
8 6 4 2 0 -2 -4 -6 -8 1993
1996
1999
2002
2005
2008
2011
Figure 8. Total miles driven 12-month moving average, year-on-year change through December 2011
8 6 4 2 0 -2 -4
Source: U.S. Department of Transportation
1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011
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China: Soft landing now, uncertainty later

ChINA
by Dr. Ira Kalish
The Chinese economy grew 9.2 percent in 2011, and it is widely expected to grow significantly slower in 2012. The questions is how much slower. The Chinese government recently revised its own forecast for 2012 growth from 8 percent to 7.5 percent. Such growth would be widely seen as a soft landing. It is the result of slower growth overseas having a negative impact on export growth. On the other hand, the central bank has eased monetary policy in order to boost domestic demand to offset the decline in exports. The details As of now, the economy is gradually moving in a negative direction. In the first two months of 2012, there was a decline in exports and a decline in the flow of foreign direct investment into China. As of March, there have been four consecutive months of declining manufacturing activity, according to a survey of purchasing managers conducted by the private sector. Investment in both residential and commercial property has tailed off, and government spending on infrastructure has slowed down. In addition, Chinese demand for commodities has decelerated, boding poorly for industrial output. All of this was due largely to the slowing of economic activity outside of China, principally in Europe. In response to this slowing, Chinas central bank has twice lowered the required reserve ratio for commercial banks with the intention of boosting liquidity and credit market activity. Still, the combined drop in the reserve ratio of 100 basis points does not come close to offsetting the 600 basis point increase that took place over the past two years. That tightening of monetary policy had taken place in order to fight inflation, a fight that has largely been a
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success. That is why the central bank is now comfortable engaging in a gradual easing of monetary policy. More is expected. The success of the easing of monetary policy is evident by the gradual nature of the slowdown often called a soft landing. Indeed, the Conference Boards index of leading economic indicators for China actually rose in January, suggesting that prospects in the months ahead are fairly good. In addition, government policymakers have signaled a willingness to take new action to offset the negative headwinds facing China. For example, the government is trying to boost first-time home ownership by providing first-time buyers with incentives in the form of low interest rates and small down payments. This is at a time when the government continues its efforts to puncture the housing bubble and discourage speculative activity in the housing market. The government has also targeted the rural sector for an easing of credit market conditions. In addition, recent government actions have been designed to boost consumer purchasing power as well as alleviate income inequality. In Beijing, Shenzhen, and Shanghai, the minimum wage has substantially increased. In the last week of February, the minimum wage in Shanghai rose 13 percent. This follows an average 22 percent increase in the minimum wage in 2011 in 24 major cities. The idea is to boost consumer spending, enable factory workers to improve their standard of living, reduce income inequality, and reduce the risk of social unrest.
China
Geographies
Longer term Recovery overseas will eventually lead to a revival of strong growth in China. Or will it? The problem is that, although China seems destined to avoid a hard landing for now, there are reasons to worry about this further down the road. The ability of China to maintain growth in the wake of the crisis in 20082009 was due to massive government support for investment. This investment now represents 48 percent of GDP, widely viewed as unsustainable as has been discussed on these pages in the past. That is why there has been much discussion lately about reform in China. The government recently cooperated with the World Bank in producing a report titled China 2030, which offers ideas on how China can sustain growth going forward. The report says that Chinas current economic model is not sustainable and must be changed. It calls for more privatization of state-run enterprises, more reliance on market forces, the end of restrictions on internal migration, a boost to the social safety net in order to encourage more consumer spending, more transparent capital markets in order to funnel capital to the most profitable investments, and better fiscal controls for local governments that are currently laden with debt. It is not likely that these or other reforms will be enacted this year. That is because 2012 is a year of transition to new leaders. The outgoing Premier, Wen Jiabao, has spoken out about the urgent need for reforms. Incoming Premier Li Keqiang said that China must deepen reforms on taxes, the financial sector, prices, income distribution, and seek breakthroughs in key areas to let market forces play a bigger role in resource allocation. Yet, there
has been nothing more specific than this. Consequently, there is some uncertainty as to nature and timing of future reforms. Failure to reform could allow imbalances to fester, leading to a crisis in the future. Reforms, on the other hand, could be disruptive and might challenge the interests of those that benefit from the current system. As such, China has no easy path. Meanwhile, the leadership debates the proper role of government, the growing problem of income inequality, and the degree to which changes in the political system are needed to ensure economic reform. Stay tuned. Kicking the can down the road In a year when political power will be transferred, the government is evidently keen to avoid major disruption to the economy. As such, it is likely that the government will utilize fiscal tools to boost economic activity if the economy faces even greater headwinds from abroad. In addition, the government has shown a desire to avoid, or at least postpone, the turmoil that might come from the unwinding of imbalances. Specifically, as discussed in this publication recently, local governments have accumulated about $1.7 trillion in debts that many analysts deem unsustainable. Moreover, a loss of revenue from weak land sales has exacerbated the problem of servicing this debt. Many analysts had recently been concerned about the possibility of an imminent crisis if banks were forced to write down these debts. Instead, the government has instructed banks to roll over the local government debt, thereby postponing the day of reckoning. Thus, there will probably not be a crisis any time soon.
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Ian Stewart is Chief Economist at Deloitte Research in the United Kingdom
United Kingdom: The outlook brightens

UK
by Ian Stewart
Our last article about the United Kingdom, which was written in late-December during a time of pessimism about the outlook for the euro and for European growth, concluded, What will be the signal to turn more bullish on UK growth and risk assets? For us, it is a marked easing
Figure 1. Deloitte nancial stress index
of financial and sovereign stress in the Euro area. Three months of financial and sovereign stress has, indeed, eased significantly (see figure 1), and with it, the outlook for the UK has brightened.
300 250 200 150 100 50 0 2006 2007 2008 2009 2010 2011 2012
The Deloitte Financial Stress Index is an arithmetic average of the ratio of the three-month LIBOR to base rates, the ratio of yield on high yield bonds to yield on government bonds, the VIX index, the ratio of total market return to banking stocks return and the ratio of yield on long-term government bonds to yield on short-term bonds.
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UK
Geographies
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Figure 2. Financial prospects Net % of CFOs who are more optimistic about nancial prospects for their company now than three months ago
More optimistic 70% 50% 30% 10% -10% -30% -50% -70% Less optimistic 2007 2008 2009 2010 2011 2012 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1
Source: Deloitte CFO Survey
Changes in the outlook are often seen first in survey data, and a number of surveys point to a bounce in business confidence. The first quarter Deloitte UK CFO Survey shows that confidence among Chief Financial Officers about their own firms finances has risen at the fastest rate since 2007, taking it close to levels last seen in late 2010 (see figure 2). The worries about the risk of recession and a breakup of the single currency that dominated the air waves and newspapers at the end of last year have eased. On average, CFOs now assign a 30 percent probability to the UK economy seeing a double dip recession, down from 54 percent in December. In the Euro area, the extensive provision of liquidity to banks by the European Central Bank and a further debt bailout for Greece has reduced fears of an early breaking of the single currency. Last December, UK CFOs, on average, saw a 37 percent probability of one or more members of the single currency leaving the euro in 2012, and this clearly weighed on business confidence. By March, this probability of secession fell to 26 percent. Easier policy has also helped confidence and boosted financial risk appetite. The United States, UK, Japan and Switzerland have been busy pushing money into the system through quantitative easing. Stronger financial conditions, reflected in rising global equity markets, seem to be benefiting larger UK companies, with CFOs reporting an increase in credit availability in the first quarter. This more than unwinds the deterioration in credit availability seen in December, which at the time, some feared could be the start of a second credit crunch. And, as a very open economy, the UK has also benefitted from the growing mood of optimism about the U.S. economy over the last few months. It would be a premature to suggest that the UK economy is out of the woods. UK GDP growth in the first half of 2012 is likely to be anemic at best. While the Bank of England thinks the UK should be able to avoid a recession, the OECD reckons the UK entered a technical recession in late 2011. And, of course, the future remains unpredictable. The deterioration in UK and European growth prospects in the second half of 2011 (see figure 3) derailed what, in early 2011, seemed like a solid recovery. That episode underscored how macroeconomic risks can escalate. Those risks may have receded, but they have
Figure 3. Consensus GDP growth forecasts for 2012
3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0 -0.5% -1.0% Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Britain US Japan
Euro area
Source: Consensus forecasts from The Economist

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UK
Geographies
hardly been eliminated. From the high oil price to the recent focus on Spains debt problems, the risks to the recovery are changeable and numerous. In the background is the worry that rates of UK GDP growth could remain anemic for years to come. On average, economists expect UK growth over the next few years to run at significantly lower levels than were seen in the years before the recession. Current near-record levels of UK corporate cash may well be a manifestation of caution on the part of corporates and insurance against a volatile, slower-growth world in which the availability of capital can shift quickly. Yet, it is the corporate sectors hiring, exports, and capital spending that are widely expected to drive the UK recovery. A rebound in corporate sector activity may be later in arriving than previously thought (see figure 4). In the last six months, the UKs official, independent forecaster, the Office of Budget Responsibility, has cut its forecast for capital spending in 2012 from 7.7 percent to just 0.7 percent.
With the UK in its third year of a seven-year program of fiscal austerity, government spending will make no contribution to the recovery. Households face a multi-year deleveraging and rising unemployment, but, after a double dip recession for the consumer last year, things are looking up. Falling inflation should support real incomes. UK consumers days of free spending are over, but household spending should make some modest contribution to GDP growth in 2012. Overall, 2012 is likely to be a year of erratic, sluggish UK growth, which is likely to come in at well under 1.0 percent for the year as a whole. Hopes for a more robust recovery now reside toward the end of the year and in 2013. Whether that recovery materializes depends as much on financial and economic conditions outside the UK and especially in the Euro area as it does on the actions of UK policymakers.
Figure 4. UK private and public sector job growth (thousands)
400 300 200 100 0 -100 -200 -300
Private sector job growth Public sector job growth
2007 Q1
Q2
Q3
Q4
2008 Q1
Q2
Q3
Q4
2009 Q1
Q2
Q3
Q4
2010 Q1
Q2
Q3
Q4
2011 Q1
Q2
Source: ONS
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Siddharth Ramalingam is an Assistant Manager at Deloitte Research, India
India: A delicate balance

INDIA
by Siddharth Ramalingam
Growth is slowing down, investment is falling, and business sentiment is on the decline. The recent Union Budget and policy announcements by the central bank have not mollified fears of possible economic slowdown. All quarters of the economy are hoping for more in terms of measures to ensure long-term inflation stabilization, reduction of the fiscal deficit, and a drop in interest rates. All is not well in the workhouse For the last several months, the Indian economy has been torn between controlling inflation and maintaining robust economic growth. In order to control skyrocketing inflation, the Reserve Bank of India chose to sacrifice growth in order to rein in inflation. The 20-month period, until October 2011, of rising interest rates has slowly but surely put the brakes on economic growth. Industry is increasingly worried about the high cost of capital, and the manufacturing sector is showing signs of stagnation.
GDP growth in the third quarter of the current fiscal year came in at a woeful 6.1 percent, marking a sharp drop from 7.7 percent growth in the first quarter, and 6.9 percent in the second quarter. Manufacturing growth slipped to 0.4 percent from 7.2 percent and 2.7 percent in the first and second quarters respectively. The seventh successive quarterly slowdown and the slowest growth in three years have triggered fears that the economy slowed down further in the last quarter of the current fiscal (JanuaryMarch 2012) and that overall growth for the fiscal year could fall short of the downwardly revised target of about 7.0 percent. Furthermore, despite the finance ministers exhortation that the economy will grow at about 8.0 percent in the next fiscal, it is possible that growth will stagnate at a new normal of about 6.0 percent unless significant efforts are made toward improving credit conditions and resurrecting investments in the coming months.
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India
Geographies
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Growth data from Indias eight core infrastructure sectors, although showing improvement in February after a disappointing January, provide no cause for cheer. The core sectors expanded 6.8 percent in February, compared to Januarys growth of just 0.5 percent. Growth in the factory sector slowed down for the third month in a row in March as new orders continue to fall and raw material prices headed north. The HSBC manufacturing Purchasing Managers Index fell to 54.7 in March from 56.6 in February and 57.5 in January. Indias exports grew 4.2 percent in February, the slowest pace of growth in three months. Imports, on the other hand, grew 20.6 percent, translating into a trade deficit of $15 billion. The commerce secretary recently expressed his concern over the burgeoning trade deficit as weak demand from Western markets and global political developments are likely to exert a drag on exports in 2012. Inflation: The artful dodger Although inflation dropped to a 26-month low in January, it seems unlikely that it will stabilize at the current level, casting doubts on whether the central bank can really afford to reduce interest rates at this time. Headline inflation accelerated in February after five months to about 7 percent. Core inflation, or inflation minus the effects of food and fuel prices, fell to 5.8 percent in February. While this does mean that demand-driven inflation is falling, it
could also imply that demand for manufactured goods is actually on the decline, adding credence to fears that the manufacturing sector is heading toward stagnation. Conversely, the fall in core inflation also implies a rise in food and fuel prices. After hitting near-zero inflation in January, food prices rose about 6 percent in February. Recent announcements by meteorologists predict a below-average rainfall this year, and absent any removal of supply-side bottlenecks in the agriculture sector, food inflation could spiral upward in 2012, taking overall inflation well above the governments target level of about 7.0 percent for the rest of the year. The fiscal deficit continues to be a cause for concern. Notwithstanding last financial years fiscal deficit of 5.9 percent of GDP instead of the planned level of 4.6 percent, the government has set a realistic target of 5.1 percent for the current fiscal in the recently unveiled budget. Not only may the target be unsustainably high, the credibility of the target for the current fiscal year has already been called into question by market commentators. A large fiscal deficit surely does not bode well for inflation. Policy fears The government stressed that reining in fiscal, revenue, and current account deficits while controlling inflation were the main aims of the recently unveiled budget. The proposed debt-to-GDP ratio is 45.5 percent, down from
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India
Geographies
At a time when the government can ill afford deterioration in its current account deficit, recent policy proposals seem, at the very least, badly timed.
last years 50.1 percent. The finance minister also proposed to reduce outlay on subsidies to below 2 percent of GDP from the current level of 2.5 percent. However, skeptics believe that the targets and measures proposed are neither spectacular nor attainable. It has been argued that the government has neither the political desire nor support to reduce subsidies on food, fuel, and fertilizers, apart from pushing through important policy reforms that are important for fostering growth. Furthermore, the Goods and Service Tax, the much-vaunted plan for fiscal consolidation, is pending the resolution of key issues regarding the division of revenues between the center and the states. In the run up to the budget, foreign investors had looked to the government for policies that would aid investment in India. However, post budget, there is increasing worry that recent government stances on foreign investment may not be tolerated by foreign investors. The government introduced a proposal that will allow tax authorities to crack down on companies that may have structured deals to avoid taxes. Firms, Indian and foreign, that have routed their investment in India through Mauritius are potentially under scrutiny. Another proposal to tax cross-border deals involving the transfer of Indian assets, with retrospective effect stretching back until 1962, is worrying current and potential investors. At a time when the government can ill afford deterioration in its current account deficit, recent policy proposals seem, at the very least, badly timed.
Few policy options Inflation, the barb that had threatened to derail Indias growth for several months, had been on the decline over the last several weeks. Inflation dropped to a 26-month low of 6.5 percent in January after remaining above 9.0 percent for much of 2011. However, inflation is on the rise again, and it is likely to stay in the 7.09.0 percent range in the coming months. The central bank cannot afford to conclude that the inflation will stabilize in the medium term. In fact, the central bank has announced that it would be premature for it to start reducing interest rates without seeing any abatement of inflationary threats exerted by the high fiscal deficit and global energy prices. Thus far in 2012, the central bank has already eased the reserve requirements for banks, infusing liquidity into the economy. It is likely that further liquidity could be infused into the economy in the coming months. Measures to ease liquidity may, however, not be enough to provide a much-needed fillip to the economy. Growth is slowing down, investment is falling, and business sentiment is on the decline. Absent any credible government action, the central bank may not be able to stave off calls for reducing the interest rate for too long. In the final analysis, questions about whether or not the interest rate will be reduced are giving way to when and how dramatically it will be cut.
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Japan: New risk factors

JAPAN
by Dr. Ira Kalish
Worrying about trade and debt For some time, pundits have bemoaned the fact that Japans sovereign debt is roughly 200 percent of GDP, which is widely viewed as an unsustainable number that puts Japan at risk of a financial crisis. However, other observers remain unalarmed because Japan runs a current account surplus. In other words, Japan saves so much that the savings exceeds the funds needed to service government debt and fund domestic investment. There is still money left over to lend to or invest in the rest of the world. Thus, Japans massive government debt should not be viewed as a problem because of its formidable savings. Yet, that is only true as long as Japan runs a current account surplus. That assumption is now being brought into question. In January, Japan ran a trade deficit. The current account balance is the trade balance plus net interest payments. Those interest payments are so large that Japan still had a current account surplus in January. Yet, the fact that Japan ran a trade deficit raised eyebrows. If continued, it could ultimately lead to a current account deficit. If that were to happen, servicing the large sovereign debt could be problematic. If markets perceived that to be so, they could push up the yield on Japanese government bonds, further exacerbating the problem of bringing the debt to a sustainable level. Why did Japan run a trade deficit? The main reason is that, following the earthquake, most of Japans nuclear power plants were idled. Thus, Japan had to import massive quantities of oil and natural gas in order to generate electricity, so the import bill rose. At the same time, a high valued yen conspired with weak demand in Europe to cause exports to falter. Moreover, rising oil prices could worsen the situation. The good news is that there was a trade surplus in February. Still, the stage is not yet set for a sustained improvement in the trade balance.
Aggressive monetary policy One of the problems for exporters has been the high valued yen. However, in recent months, the yen has declined somewhat, thereby boosting the competitiveness of exports. This shift was mainly due to a change in monetary policy. The Bank of Japan (BoJ) has implemented two rounds of asset purchases (often known as quantitative easing), the second of which was announced in February and involved 10 trillion yen ($130 billion). The effect of this was to boost liquidity, boost expectations of inflation, and put downward pressure on the yen. Indeed, the yen fell from roughly 77 yen per dollar to 83 yen per dollar. Now there is talk of another round of asset purchases. There are two reasons for this. First, inflation remains close to zero even though the BoJ set an explicit inflation target of 1.0 percent. While the program of asset purchases ended deflation and created a bit of inflation, it may not be sufficient. Second, there is concern that the yen could bounce back as long as the Japanese currency is seen as a safe asset in a world of risk. Further financial market stress in Europe or a stumbling of the U.S. economy could cause the yen to shoot up. Fiscal issues Meanwhile, the Japanese government is determined to put Japan on a sustainable fiscal path. Japan faces several problems. First, the debt is already very large and higher bond yields would make the situation worse. Second, Japans economy has grown very slowly, thereby generating modest revenue gains. Third, deflation meant that incomes were declining or stagnant at best, thus suppressing government revenue. Finally, the aging population means that future spending on pensions and health is likely to increase substantially. Many observers worry that, without a plan to create fiscal probity, Japan could face a serious crisis in the not-too-distant future.
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Japan
Geographies
The solution, according to Prime Minister Noda, rests in raising the sales tax from the current 5 percent to 10 percent by 2015. This plan has become hugely unpopular, and it is not clear that it will pass the Parliament. If it doesnt pass, confidence could be undermined, leading to higher bond yields. If it does pass, however, the effect on growth could be negative. Thus, Japan is caught between a rock and a hard place. Moreover, failure to pass Nodas legislation would be indicative of a larger problem of political gridlock. This means that passage of other reformoriented legislation would be less likely. Growth outlook Given the fiscal, trade, and energy situations, one could be forgiven for expecting poor economic performance. However, the reality is likely to be somewhat different at least in the short run. There are a number of factors that should boost growth in the coming year. That would be welcome, given that Japans economy shrank by 0.9 percent in 2011. Moreover, GDP declined in the fourth quarter at an annual rate of 2.3 percent. That was largely due to a decline in inventories and a drop in exports. The latter was due to the temporary effect on Japanese supply chains emanating from the floods in Thailand. The
good news is that the factors hurting growth in the fourth quarter were temporary. In 2012, growth should resume for several reasons. First, Japans government is expected to continue to spend massively on reconstruction, thereby boosting domestic demand. Second, the Thai floods are over, and supply chains have resumed. Third, the aggressive monetary policy has suppressed the yen, which should help export competitiveness. Fourth, the aggressive monetary policy has also boosted expectations of inflation, which have the effect of cutting real interest rates. This should help boost credit demand. Fifth, higher inflation could stimulate consumers to spend more. Sixth, following the depletion of inventories in the fourth quarter, businesses are likely to engage in inventory rebuilding in early 2012. Finally, the rest of the world is not doing as badly as previously expected. This should help to stabilize exports. Thus, a reasonable expectation for 2012 is that the Japanese economy will grow between 1.0 and 2.0 percent, inflation will be positive, and the yen will not resume its appreciation.
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BRAZIL
Brazil: Worried about capital inflows

by Dr. Ira Kalish
At a meeting of the BRICS countries in India in late March, the Brazilian delegation sought a statement criticizing the monetary policies of Europe and the United Sates. The statement never happened, but the fact that Brazil sought such a statement indicates what is top-of-mind for Brazilian policymakers. The low interest rate policies of Europe and the United States have led investors to look elsewhere for higher returns. Naturally, Brazil has become a favored destination for funds in search of return. After all, Brazil currently has among the highest interest rates in a stable country. The inflow of funds threatens to increase the value of the currency enough to seriously damage export competitiveness. In addition, the Brazilian government says the country is awash with cheap imports. As such, Brazil intends to complain to the WTO that the 35 percent tariff ceiling that it authorized is too low. This could alarm China, which is Brazils largest trading partner. It could also alarm other members of the WTO that are concerned about Brazils potential tilt toward protectionist policies. One solution, of course, is for Brazil to cut interest rates, and indeed, this has been happening. The problem is that Brazils inflation is lingering above the central banks target of 4.5 percent. Cutting interest rates too quickly, while beneficial to the currency, could lead to higher inflation. Moreover, higher inflation would lead to higher labor costs, thereby damaging the competitiveness of exports even more. On the other hand, failure to sufficiently cut rates could result in an increase in the value of its currency. This would be troublesome, given that exports are already faltering due to the economic slowdown in Europe. So, like many other countries, Brazil is in a difficult position. Interestingly, Brazilian policymakers complain about the inflow of capital, even as Brazil needs an inflow of capital.
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Since Brazil is running a current account deficit, meaning that the country is a net borrower, capital inflows are needed to finance the deficit. Otherwise, Brazil would have to borrow from abroad. Of course, the best kind of capital inflow would be foreign direct investment (FDI) rather than the portfolio flows now entering the country. That is because FDI is more stable and less vulnerable to the mood swings of global investors. When investors get spooked, they can withdraw their cash more easily than a factory. The current situation and the outlook After four 50 basis point interest rate cuts in the last four months, the Brazilian central bank surprised markets by cutting the benchmark rate by 75 basis points in March and another 75 in April. The benchmark rate stood at 9.0 percent as of the end of April. This follows news that Brazilian industrial production fell in January at its steepest pace in three years. Not only is the central bank trying to boost economic activity, it is also trying to reduce upward pressure on the currency, which has risen 5 percent this year. In the coming year, it is likely that interest rates will continue to be cut further in order to stimulate a relatively dormant economy. This expectation is based on the statements of Brazils central bankers. Brazil may err on the side of stronger growth rather than containing inflation. However, it is not likely that Brazil will allow inflation to get out of hand. Economic growth, which was strong in 2010, decelerated considerably in 2011. Indeed, Brazils economy stalled in the third quarter of 2011, a far cry from the rapid growth of 7.5 percent experienced in 2010. All sectors of the economy were down except for exports. Consumer spending, which accounts for 60 percent of GDP, declined. This may represent the end of the debt-fueled consumerspending boom. Business investment also dropped. Exports
Brazil
Geographies
grew, but at a slower rate than in the previous quarter. Agricultural output increased at a good pace, but industrial output was down. Clearly, the end of growth was not only due to the Eurozone crisis. Rather, the lagged effects of tight monetary policy, which subsequently reversed, may have had an impact. The government, keen to boost growth, will probably increase fiscal spending in the coming year, financed by borrowing. In addition, the government is expected to continue its auction of assets to stimulate private sector investment in infrastructure. It has already auctioned the right to operate several airports. The intended result is for investment spending to contribute to growth, the auctions to contribute to public finances, and the actual investments to boost longer-term growth prospects by improving productivity. Moreover, infrastructure investments will be critical to the preparation for the 2016 Olympics in Rio.
Another major area of investment is energy. Brazil sits astride massive ocean-based reserves of oil. Petrobras, the state-run energy company, intends to double production by the end of the decade. To do this, it may engage in more capital spending over the coming decade than any other company in the world. The bottom line is that growth in 2012 may gradually recover, assuming that outside events dont conspire to throw a monkey wrench in Brazils plans. Such events could include a deeper Eurozone recession, a steeper increase in the global price of oil, or a global financial crisis that could lead to capital flight.
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RUSSIA
Russia: Conflicting influences

by Dr. Ira Kalish
Russias economy is performing reasonably well, but it faces some obstacles going forward. In 2011, the economy grew 4.3 percent. This included consumer spending growth of 6.4 percent and investment growth of 6.0 percent. However, growth is likely to be somewhat slower in 2012, given global headwinds. Slower growth in Europe and China will have a negative impact on the volume of exports. About two-thirds of Russias exports are energy related, and energy demand may decline in these markets. In China, for example, which is Russias largest single export market, demand for energy is expected to dampen considerably. On the other hand, there has been a significant increase in the global price of oil lately, largely the result of political risk. This will boost Russian export revenues and contribute to continued trade surpluses. Influences on growth There are other factors that will influence growth in 2012. First, credit market conditions in Russia have been good. Credit for consumers and construction has grown rapidly, fueling a boom in consumer spending and construction activity. Moreover, stabilization of European financial markets the result of massive ECB lending to commercial banks bodes well for Russia. Although Russia runs a current account surplus, making it a net creditor nation, it has a deficit in net interest payments. Consequently, Russian access to global credit markets is important. With Europe evidently stabilizing, Russian credit market conditions are likely to remain relatively good. Second, wages have been rising faster than inflation. This increase in real wages has also contributed to rising consumer spending. It is largely due to a sudden
34
and unexpected decline in the rate of inflation. Lately, prices are up only 4.3 percent over a year ago. This low inflation, in turn, is partly due to the governments decision to postpone increases in a tax on energy, which was originally scheduled to be implemented in January of this year, but instead was postponed to July. Thus, inflation was temporarily suppressed. In addition, a rising value of the currency recently had a disinflationary impact. On the other hand, there is concern in the market that inflation is likely to rise in the coming year. Unless nominal wages keep up, consumer purchasing power might be negatively influenced. In addition, rising inflation is likely to constrain the central bank in its ability to operate an easy monetary policy. Thus, interest rates might not come down any further. The expected rise in inflation is due to the imminent rise in energy taxes, the impact of rising oil prices, and the lagged impact of an easy monetary policy. Third, fiscal policy has lately been expansionary in anticipation of the recent presidential election, thus contributing to economic growth. It was made possible by higher-than-expected oil prices, which have boosted government revenues. The result, interestingly, has been a budget surplus when the government had originally anticipated a deficit in the year that just ended. In the coming year, government expenditures are likely to continue growing in areas such as defense, public sector compensation and pensions, infrastructure, and social spending. Again, this is feasible given the relatively high price of oil. On the other hand, it is estimated that if elevated spending is maintained, Russia will require an oil price of about $120 per barrel in order to balance the budget. As recently as 2007, an oil price of $55 was sufficient to balance the budget. The risk for Russia is
Russia
Geographies
that if the price of oil were to decline, then fiscal probity would be thrown into question. The government would then face a choice of fiscal contraction, which would have a negative impact on GDP growth, or continued borrowing and spending. Given that the currently high price of oil is largely related to a political risk premium, the possibility of a drop in the price cannot be dismissed. Fourth, capital flight remains a problem and reflects a dearth of confidence in Russias immediate future. Capital flight diminishes business investment from what it otherwise would be. Interestingly, capital flight is taking place at the same time that foreign direct investment is increasing. The latter reflects increased investment in the energy sector, especially as the government has lately taken a more open attitude toward foreign involvement in energy development. Despite capital flight, the currency recently rose in value, reflecting the rise in oil prices. Longer term issues Vladimir Putin was recently elected president for the third time, replacing outgoing President Medvedev. He will now serve a six-year term. His margin of victory was substantial and, therefore, sufficient to quash skepticism. Although
we know who will lead Russia, the policy regime remains somewhat murky. It is not known whether Mr. Putin will move toward market orientation or support a more statist set of policies. Notably, Mr. Putin has cited China and South Korea as examples of favorable growth environments. China, in particular, has relied heavily on state direction of the economy, while South Korea relied on state protection of favored industries in the early stages of its industrial development. As such, Putins comments suggest a good deal of government involvement in economic management. On the other hand, Russia is set to join the World Trade Organization (WTO) this year. Membership will require more openness on trade-related issues. The most pressing challenge that Mr. Putin will face in the coming years is the level of investment as a share of GDP. Currently, it is inadequate for generating strong growth. Moreover, the level of investment in the energy industry, while rising, remains insufficient to substantially boost production. Boosting investment, in part by generating more foreign direct investment, will be critical.
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Pralhad Burli is a Senior Analyst at Deloitte Research, India
INDONESIA
Indonesia: Unlocking potential

by Pralhad Burli
While several European economies are reeling under the shadow of a worsening debt crisis, Indonesias performance has been nothing short of stellar. In 2011, the economy grew at its fastest pace in over 15 years. Robust economic growth backed by fiscal prudence prompted rating agencies to raise Indonesias sovereign credit rating. Moreover, Indonesias economy has shown remarkable resilience following the currency crisis of the late 1990s, and it is currently better positioned to handle external shocks. As a result, economists, finance specialists, and international investors have plenty of reasons to be excited about Indonesias prospects. A macroeconomic mixed bag With nearly 240 million people, Indonesia is the fourth most populous country in the world. Furthermore, more than half the population is under the age of 30. At over $3,300, Indonesias per capita income is over twice as high as Indias. While there is a huge disparity in income levels, the gap is expected to narrow. In addition, Indonesia is likely to experience a significant shift in its consumer market as a large portion of its population enters the middle class. As a result, Indonesia is a very important consumer market, and domestic consumption remains an economic mainstay. International retailers, as a result, can make a strong case for entering or expanding operations in Indonesia over the next few years.
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If the governments plan to roll back fuel subsidies takes effect, private consumption growth will likely shrink in 2012. Given the subsidy cut, consumption may not attain its pre-crisis growth rate anytime soon. On the other hand, a delay in implementing the fuel subsidy cut will boost disposable income and consumption in the near term. Meanwhile, Indonesias reliance on exports is much lower than its regional peers. However, surging commodity prices turned Indonesian exports into a significant driver of economic growth, and resource-hungry nations such as India and China provide ready markets for Indonesian commodities. Moreover, Indonesias strategic location has led to strong trade relations with additional countries in Asia and Oceania. Exports supported economic growth during a period of subdued domestic demand, but ongoing reliance on export-led growth could make its economy vulnerable to external shocks. A weak recovery in the United States and the potential exacerbation of the Eurozone crisis pose significant downside risks. Furthermore, an economic slowdown in China coupled with cooling commodity prices could result in substantially shrinking export revenues.
Indonesia
Geographies
A step in the right direction Indonesias parliament passed the land acquisition bill in December 2011, and it now awaits the presidents approval. The land acquisition bill, if approved and implemented expeditiously, has the potential to spur additional economic growth. The bill will likely reduce bottlenecks in land acquisition for infrastructure projects by streamlining the mechanism for compensating land owners, significantly reducing bureaucratic interference. The bill is expected to allow the government to fast-track infra-
structure development and also attract private sector participation. These developments are favorable as the lack of adequate infrastructure is often touted as the most important impediment to Indonesian growth. However, as of now, Indonesias prospects are comparatively positive. The recent sovereign rating upgrade could spur foreign investors and lead to a surge in foreign inflows in 2012. As Indonesia embarks on an ambitious plan to boost spending in infrastructure development,
37
foreign capital can play a critical role in bridging the investment gap. Furthermore, the governments push to develop value-added industries, if successful, could benefit the economy over the medium and long term. Indonesias economic fundamentals are robust. Policies that leverage Indonesias strengths can potentially catapult the economy to achieve GDP growth rates beyond 7 percent. Smaller is better As the developed world struggles with huge deficits and debt, Indonesias strength lies in its low debt profile and small budget deficit, which was a mere 1.1 percent of GDP in 2011. The governments expenditure on subsidies was higher than anticipated, but strong revenues combined with lower spending on capital projects and social initiatives offset these additional costs. Given robust GDP growth, tax revenues will likely remain strong in 2012. Current projections peg the deficit at 1.5 percent of GDP in 2012. However, if the government is unable to implement its rollback on subsidies and oil prices shoot up due to geopolitical uncertainty, Indonesias budget deficit will, in all likelihood, be higher. Despite this downside risk, Indonesias budget does not pose a significant challenge to its economy. On the contrary, Indonesias problems stem from unspent allocations for public projects. Meanwhile, fiscal prudence put a lid on inflation, allowing the central bank sufficient leeway in pursuing an easy monetary policy. The Bank of Indonesia has been fairly
38
proactive in its policy actions. In the Board of Governors meeting in February, the Bank of Indonesia cut its interest rate by 25 basis points to 5.8 percent. The move came as a surprise, but it underscores Indonesias concern about growth prospects in the weak global macroeconomic environment. The rate cut also highlights the confidence of the Bank of Indonesia in implementing a countercyclical monetary policy while maintaining its inflation targets and exchange rate. The country has benefitted from ebbing inflation, but this trend will likely reverse during the latter half of the year if subsidies are rolled back. The Bank of Indonesia is expected to uphold its policy stance in the near term and remain vigilant to emerging risks. A further interest rate cut is unlikely. However, the looming risk of a worsening global economy will ensure that monetary policy is not tightened prematurely. In addition, robust GDP growth and limited borrowing requirements will reduce the debt-to-GDP ratio to below 24 percent in 2012. Indonesias outstanding public debt 24.3 percent of GDP in 2011 is much lower than the emerging market average of 37.8 percent. Moreover, contingency proposals that allow the government to draw on deposits accumulated through excess borrowing in the past provide a buffer. If conditions deteriorate, resulting in smaller revenues or larger expenses, the government has the means to stimulate the economy.
Indonesia
Geographies
Persistent challenges Pervasive corruption is a major impediment to Indonesias growth prospects. Bureaucratic bottlenecks, political interference, and judicial inefficiencies weigh on foreign investment and private sector participation in Indonesia. Of late, the government has initiated several anticorruption measures to improve governance. Several offenders have been prosecuted and even jailed. The recent crackdown on corruption has also resulted in bureaucratic reluctance in spending money even on worthwhile projects. Yet, new cases of tax evasion and bribery continue to be the order of the day. Corruption and bureaucratic delays also weigh on Indonesias competitiveness. Indonesias poor performance on global comparison metrics such as days required to start a business, cost to start a business, number of procedures, etc. are a significant deterrent to investors. Together, these factors result in less-than-favorable conditions for global manufacturers to invest in Indonesia. The country also fares poorly in terms of diversification of industries and a dearth of value-added industries. Furthermore, poor labor laws result in frequent labor union strikes, road blockages, and production disruptions. As a result, Indonesias labor advantage remains underutilized. The government faces the uphill task of strengthening institutions, ushering labor reforms, and altering Indonesias image in the eyes of potential investors.
Moreover, the country lacks adequate infrastructure to support its growth aspirations. Infrastructure inadequacies result in connectivity breakdowns, adding to transportation and distribution costs and eventually higher inflation. Indonesias ports and airports are in need of improvement and cannot cater to high-capacity vessels. While the government has indicated its desire to remove infrastructural bottlenecks, whether the plan will be backed by credible action remains to be seen. A slowing world economy will definitely impact Indonesias growth prospects in one way or another. Slowing commodity prices could drive down export revenues and result in economic deceleration. However, domestic demand could partially offset the decline in external demand. Growth in Indonesian tourism has been curtailed by instances of terrorism. Notwithstanding the downside, Indonesias economy has significant potential. Foreign investment could increase if investors make long-term investments by pursuing high returns in Indonesia. Furthermore, private investment will likely increase if authorities can establish legislative certainty. Overall, the economy is expected to grow by 6.5 percent in 2012. However, if the government succeeds in eliminating bottlenecks that hold back Indonesias growth, the economy could outperform consensus expectations.
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Dr. Satish Raghavendran is Vice President at Deloitte Research, India
Neha Jain is an Analyst at Deloitte Research, India
Trade patterns of the future: Waking up and smelling the coffee

by Dr. Satish Raghavendran and Neha Jain
It is becoming apparent that China may be losing its status as the factory of the world. Cost economics that long worked in Chinas favor have come full circle; domestic wages are on the rise, eroding much of the cost arbitrage offered to foreign companies. Even Chinese companies are affected as improving living conditions in the hinterland discourage potential migrants from seeking work in urban coastal provinces. Furthermore, an aging population in the next decade will likely weigh down labor supply and impact wage competitiveness. As Chinese production moves up the value chain, workers are demanding higher wages, better working conditions, and added welfare benefits. Thus, rising labor costs, along with pressure to loosen control on its exchange rate, could pose a serious threat to Chinas international competitiveness if productivity does not correspondingly improve. Economists have already begun speculating the end of cheap China, beckoning some companies to reassess their Chinese footprint and proactively explore other low-cost geographies in emerging trading networks. While China may lose its sheen as the factory of the world, companies could benefit from leveraging the emerging Asian networks for low-tech, labor-intensive trade and production. Rapid-growth economies such as Bangladesh and Vietnam are catching up quickly, providing cheap alternative destinations. Todays supply chains mimic complex webs involving minute levels of intermediate production rather than locally produced
40
finished goods. This structure presents immense opportunities for emerging markets to develop specific capabilities and capture a bigger share of the supply chain. From a companys perspective, an emerging trade network with a wide portfolio of capabilities allows for diversification of the supply chain rather than extreme reliance on a single country whose competitiveness may be decreasing. Nonetheless, China will remain an important, if not dominant, player in the future. The countrys burgeoning middle class is set to become more affluent and boost consumption levels in the next decade. It is estimated that urban household disposable income will grow almost twofold between 2010 and 2020, fueling discretionary spending. The government itself is strategically envisaging a shift away from a reliance on exports in favor of a more consumption-driven economy in the future. Chinas 12th Five-Year Plan for 20112015 calls for higher minimum wages, income tax reform, and increased welfare schemes, all of which will likely boost consumption in the future. The Plan further highlights the governments ambition to move away from just being the worlds factory to transforming Chinas coastal regions into hubs of research and development or high-tech manufacturing. Thus, as China moves up the value chain from made in China to made for China, it will likely leave room for other emerging economies to gain a larger share of global trade. The most obvious contenders are India and other APAC economies within Chinas trading network. However, China and
Topics
Indias recent economic interest in Sub-Saharan Africa and the Middle East is a testament to the growing alliance between these regions, which could significantly alter trade patterns of the future. Silk road to Africa Trade linkages between China, India, and Africa date back centuries to the era of the Silk Road, which primarily involved the trade of silk, tea, porcelain, spices, and other luxury goods. However, the 21st century has seen a newfound interest in trade with Africa, which is evident from the proliferation of not just goods and services but also massive foreign investment, technology transfer, and the movement of human capital. In recent years, Africas trade with Asia has been booming, surpassing trade volumes with the European Union and the United States, Africas traditional trading partners. During 20032010, Africas exports to China and India surged by about 3132 percent per year, with the bulk going to China. During the same period, imports from China grew at an almost
identical pace of 32 percent, and imports from India grew at 28 percent per year. Thus, these countries are growing their trade relationship. With vast natural reserves and ample availability of arable land, Africa came under the Asian radar as a source of energy and food security. The voracious appetite of Asian Tigers drove them to import high volumes of resource commodities from Sub-Saharan Africa. However, China and Indias industrial capabilities have become more sophisticated, requiring more diversified, labor-intensive imports such as light manufactured goods and household consumer goods from Africa. Consequently, the Asian interest in African exports has expanded beyond traditional oil and food imports to manufactured goods and services. Multinational firms are increasingly recognizing the long-term growth prospects of Africa. By 2020, more than 50 percent of Africas population will have discretionary income (beyond basic needs); meanwhile, the
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labor force will be steadily expanding too. The African continent constitutes almost 60 percent of the worlds arable yet uncultivated land that is waiting to be tapped. Furthermore, the heterogeneity of African countries offers the advantage of diverse capabilities across the value chain to foreign firms. Although political stability and infrastructure bottlenecks present challenges, many countries have taken credible steps toward regulatory reform, improved macroeconomic stability, and trade liberalization. China and to some extent India are key participants in African infrastructure development and have invested a significant amount into the sector in exchange for a larger share of Africas natural resources. This growing partnership between Asia and Africa is representative of a strength42
ening trade network and mutual dependence. As China moves up the value chain, Africa will likely offer an attractive alternative for low-cost production, supported by its booming domestic consumer markets. Middle East rising Countries in the Middle East, especially those in the Gulf (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and UAE), are proactively forging trading alliances with Asian countries, reflecting their collective aspiration to diversify their domestic economies beyond oil exports. The composition of trade patterns from the Gulf Cooperation Council (GCC) reflects a significant increase in trade flows with BRIC countries (19.4 percent) compared to those with
Topics
As economies in Sub-Saharan Africa and the Middle East develop and open up to trade, links between Asia, the Middle East, and Africa are expected to flourish.
NAFTA (8.9 percent), revealing a more diversified export basket. Statistics reveal that Gulf exports to Asia, particularly China, cover a range of products like plastics, electronic equipment, and vehicles, while exports to the United States predominantly comprise oil and oil products. The strategic partnering of the GCC countries with China, India, and other economies focuses on building manufacturing bases in order to produce a wide array of products of varying complexity and to develop skills in critical areas such as water desalination, digital infrastructure, and education. The GCC has engaged China to assist with setting up telecom networks and developing knowledgebased economies. The investment in these areas has the potential to transform the Gulf into a preferred destination of global supply chains that offer world-class infrastructure as well as access to talent and domestic consumer markets. A robust and well-diversified manufacturing base will be critical in driving prosperity of this region. The key enabler for this transformation could potentially be the policy reforms that facilitate economic integration and lower barriers for businesses. Another important influencer of strategic investments is the GCCs deployment of sovereign wealth funds, which stand at $1.1 trillion. The GCC governments are committed to developing their strengths in areas like energy and services while enhancing allied sectors. This trend is likely to continue as the GCC governments proactively seek and incentivize foreign business.
Emerging trade hubs As economies in Sub-Saharan Africa and the Middle East develop and open up to trade, links between Asia, the Middle East, and Africa are expected to flourish. Economic integration between these regions and the emergence of South-South trade will likely result in the formation of influential trade hubs. The trade of the future will be determined by the availability of cheap resources and the destination of final demand itself. Some firms in developed economies have already begun to question whether the challenges of outsourcing their production processes outweigh the benefits of producing locally. In this respect, Africa and the Middle East offer both low-cost production capabilities as well as a rapidly growing domestic market. While there are political and economic risks, a burgeoning consumer base will likely induce foreign business to navigate these markets and leverage locally available resources in a more cost-effective way. Supply chain disruptions following the earthquake in Japan also have highlighted the challenges of extreme specialization and reliance on a few economies. Another advantage that the Middle East and Africa offer is the close proximity to European markets. Thus, the emergence of Africa and the Middle East as new trade hubs is likely to play a pivotal role in connecting people, products, and technology.
References and research sources: OECD, Going for Growth, 2012. 43
Appendix
GDP Growth Rates (YoY %)*
8 6 4 2 0 -2 -4 -6 -8 -10 -12 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 07 07 07 07 08 08 08 08 09 09 09 09 10 10 10 10 11 11 11 11 -10 -15 0 -5
GDP Growth Rates (YoY %)*

India's scal year is April-March
20 15 10 5
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 07 07 07 07 08 08 08 08 09 09 09 09 10 10 10 10 11 11 11 11
U.S.
U.K.
Eurozone
Japan
Brazil
China
India
Russia
Ination Rates (YoY %)*

6 5 4 3 2 1 0 -1 -2 -3 Jan 09 May 09 Sep 09 Jan 10 May 10 Sep 10 Jan 11 May 11 Sep 11 Jan 12
Ination Rates (YoY %)*

Ination data for India is based on the WPI 16 14 12 10 8 6 4 2 0 -2 -4 Jan 09 May 09 Sep 09 Jan 10 May 10 Sep 10 Jan 11 May 11 Sep 11 Jan 12
U.S.
U.K.
Eurozone
Japan USD-Yen
100
Brazil
China
India
Russia
Major Currencies vs. the US Dollar*

1.8 1.7 1.6 1.5 1.4 1.3 1.2 1.1 1 Jan 09
95
90
85
80
75 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12
GBP-USD
Source: *Bloomberg 44
Euro-USD
USD-Yen (RHS)
Appendix
Yield curves (as on April 6, 2012)*
U.S. Treasury Bonds & Notes 3 Months 1 Year 5 Years 10 Years 0.01 0.07 1.01 2.18 UK Gilts 0.00 0.45 1.07 2.21 Eurozone Govt. Bencmark 0.09 0.28 0.77 1.79 Japan Sovereign 0.10 0.10 0.33 1.00 Brazil Govt. Benchmark 8.98 8.93 10.73 11.29 China Sovereign 2.75 2.84 3.14 3.52 India Govt. Actives 8.92 8.26 8.72 8.78 Russia 6.06 6.33 7.51 8.16
Composite Median GDP Forecasts (as on April 6, 2012)*

US 2012 2013 2014 2.2 2.4 2.85 UK 0.6 1.75 1.95 Eurozone -0.4 1.05 2.4 Japan 1.54 1.49 1.1 Brazil 3.4 4.5 China 8.3 8,4 Russia 3.5 3.7 4
Composite median currency forecasts (as on January 9, 2012)*

Q2 12 GBP-USD Euro-USD USD-Yen USD-Brazilian Real USD-Chinese Yuan USD-Indian Rupee* USD-Russian Ruble 0.83 1.29 82 1.78 6.25 51 29.65 Q3 12 0.83 1.3 83 1.75 6.21 50 29.7 Q4 12 0.83 1.31 84 1.74 6.12 49 29.6 Q1 13 0.83 1.33 84.5 1.75 6.08 48.13 29.7 2012 0.83 1.31 84 1.74 6.12 49 29.6 2013 0.82 1.31 87.5 1.75 5.96 47 29.75 2014 0.81 1.29 94 1.75 6 46 33.49
OECD Composite leading indicators (Amplitude adjusted)

U.S. Mar 10 Apr 10 May 10 Jun 10 Jul 10 Aug 10 Sep 10 Oct 10 Nov 10 Dec 10 Jan 11 Feb 11 Mar 11 Apr 11 May 11 Jun 11 Jul 11 Aug 11 Sep 11 Oct 11 Nov 11 Dec 11 Jan 12 *Source: Bloomberg MICEX rates Source: OCED Note: A rising CLI reading points to an economic expansion if the index is above 100 and a recovery if it is below 100. A CLI which is declining points to an economic downturn if it is above 100 and a slowdown if it is below 100. Source: OECD 99.9 100 100 99.8 99.6 99.6 99.8 100.1 100.6 101.2 101.7 102 102.1 102 101.7 101.3 100.8 100.4 100.4 100.6 101.1 101.8 102.5 UK 104.1 103.9 103.5 103.2 102.9 102.7 102.6 102.6 102.6 102.7 102.7 102.6 102.5 102.2 101.8 101.3 100.7 100 99.4 99 98.7 98.7 98.9 Eurozone 103.2 103.4 103.5 103.5 103.6 103.6 103.7 103.9 104.1 104.2 104.3 104.1 103.8 103.3 102.6 101.7 100.8 100 99.2 98.7 98.5 98.5 98.7 Japan 99.9 100 100.1 100.1 100.1 100.2 100.5 100.8 101.3 101.9 102.3 102.6 102.6 102.3 102 101.7 101.4 101.2 101.2 101.3 101.6 102.1 102.6 Brazil 103.3 103.4 103.3 103.1 102.9 102.8 102.9 103.2 103.4 103.5 103.2 102.8 102.2 101.4 100.3 99.1 97.7 96.5 95.5 94.6 93.8 93.4 93.2 China 102.5 102.1 101.6 101.2 100.9 100.9 101.1 101.4 101.6 101.8 101.8 101.7 101.5 101.2 101 100.8 100.6 100.4 100.2 99.9 99.5 99 98.4 India 103.4 103.2 102.9 102.6 102.3 102.2 102.1 101.9 101.7 101.4 100.9 100.2 99.3 98.3 97.3 96.4 95.7 95.2 94.9 94.9 95.4 96 96.7 Russia 98.4 98.9 99.3 99.9 100.5 101.2 101.9 102.6 103.1 103.6 103.7 103.8 103.5 103.2 102.8 102.5 102.2 101.9 101.8 101.7 101.8 101.9 102.1
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Additional resources
Deloitte Research Thought Leadership

Deloitte Review Issue 10 A Delicate Balance: Organizational barriers to evidence-based management To Thine Own Self Be True: Sustaining superior performance requires knowing what should change and what should stay the same The Mobile Elite: Meeting the growth challenge in the 4G era The Talent Paradox: Critical skills, recession and the illusion of plenitude A crisis of the similar Asia Pacific Economic Outlook: China, Japan, The Philippines, Singapore, Taiwan Fed Cloud: The future of federal work Please visit www.deloitte.com/research for the latest Deloitte Research thought leadership or contact Deloitte Services LP at: research@deloitte.com. For more information about Deloitte Research, please contact John Shumadine, Director, Deloitte Research, part of Deloitte Services LP, at +1 703.251.1800 or via e-mail at jshumadine@deloitte.com.
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Appendix
Contact information
Global Economics Team Ryan Alvanos Deloitte Research Deloitte Services LP USA Tel: +1.617.437.3009 e-mail: ralvanos@deloitte.com Pralhad Burli Deloitte Research Deloitte Services LP India Tel : +91.40.6670.1886 e-mail: pburli@deloitte.com Dr. Elisabeth Denison Deloitte & Touche GmbH Germany Tel: +49.89.29036.8533 e-mail: edenison@deloitte.de Neha Jain Deloitte Research Deloitte Services LP India Tel: +91 40 6670 3133 e-mail: nehajain59@deloitte.com Dr. Ira Kalish Deloitte Research Deloitte Services LP USA Tel: +1.213.688.4765 e-mail: ikalish@deloitte.com Dr. Satish Raghavendran Deloitte Research Deloitte Services LP India Tel: +91 40 6670 3304 e-mail: sraghavendran@deloitte.com Siddharth Ramalingam Deloitte Research Deloitte Services LP India Tel : +91.40.6670.7584 e-mail: sramalingam@deloitte.com Dr. Carl Steidtmann Deloitte Research Deloitte Services LP USA Tel : +1.303.298.6725 e-mail: csteidtmann@deloitte.com Ian Stewart Deloitte Research Deloitte & Touche LLP UK Tel: +44.20.7007.9386 e-mail: istewart@deloitte.co.uk Global Industry Leaders Consumer Business Lawrence Hutter Deloitte LLP UK Tel: +44.20.7303.8648 e-mail: lhutter@deloitte.co.uk Energy & Resources Peter Bommel Deloitte Netherlands Netherlands Tel: +31.6.2127.2138 e-mail: pbommel@deloitte.nl Financial Services Chris Harvey Deloitte LLP UK Tel: +44.20.7007.1829 E-mail: caharvey@deloitte.co.uk Life Sciences & Health Care Robert Go Deloitte Consulting LLP USA Tel: +1.313.324.1191 e-mail: rgo@deloitte.com Manufacturing Hans Roehm Deloitte & Touche GmbH Germany Tel: +49.711.16554.7130 e-mail: hroehm@deloitte.de Public Sector Greg Pellegrino Deloitte Consulting LLP USA Tel: +1.571.882.7600 e-mail: gpellegrino@deloitte.com Telecommunications, Media & Technology Jolyon Barker Deloitte & Touche LLP UK Tel: +44 20 7007 1818 e-mail: jrbarker@deloitte.co.uk U.S. Industry Leaders Banking & Securities and Financial Services Robert Contri Deloitte LLP Tel: +1 212 436 2043 e-mail: rcontri@deloitte.com
Consumer & Industrial Products

Craig Giffi Deloitte LLP Tel: +1.216.830.6604 e-mail: cgiffi@deloitte.com
Health Plans and Health Sciences & Government

John Bigalke Deloitte LLP Tel: +1.407.246.8235 e-mail: jbigalke@deloitte.com
Power & Utilities and Energy & Resources

John McCue Deloitte LLP Tel: +216 830 6606 e-mail: jmccue@deloitte.com
Public Sector (Federal)

Robin Lineberger Deloitte Consulting LLP Tel: +1.517.882.7100 e-mail: rlineberger@deloitte.com
Public Sector (State)

Bob Campbell Deloitte Consulting LLP Tel: +1.512.226.4210 e-mail: bcampbell@deloitte.com
Telecommunications, Media & Technology

Eric Openshaw Deloitte LLP Tel: +1 714 913 1370 e-mail: eopenshaw@deloitte.com
47
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Global Economic Outlook Q2 2012

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Global Economic Outlook Q2 2012

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A Deloitte Research publication | 2nd Quarter 2012

A Collective Sigh of Relief

Global Economic Outlook Q2 2012

Dr. Ira Kalish Director of Global Economics Deloitte Research

Global Economic Outlook 2nd Quarter 2012

Dr. Alexander Brsch is Head of Research, Deloitte Germany

Eurozone: Could this be the turning point?

by Dr. Alexander Brsch

Figure 1. Use of ECB's deposit facility (EUR millions)

900,000.00 Deposit facility 800,000.00

Source: European Central Bank

Global Economic Outlook 2nd Quarter 2012

Figure 2. Economic Sentiment Indicator

120 100 80 60 40 20 0 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12

Germany France Euro area Spain Italy Greece

Global Economic Outlook 2nd Quarter 2012

Greece Italy Spain France Euro area

Dr. Carl Steidtmann is Chief Economist at Deloitte Research

United States: Why the euphoria?

Global Economic Outlook 2nd Quarter 2012

250% 200% 150% 100% 50% 0%

Source: Energy Information Administration, St. Louis Federal Reserve

Global Economic Outlook 2nd Quarter 2012

Source: U.S. Federal Reserve

Figure 5. Equally weighted coincidental indicator (Percentage change year-over-year)

Global Economic Outlook 2nd Quarter 2012

Energy prices and consumer behavior

Source: U.S. Energy Information Administration

Global Economic Outlook 2nd Quarter 2012

China: Soft landing now, uncertainty later

by Dr. Ira Kalish

Ian Stewart is Chief Economist at Deloitte Research in the United Kingdom

United Kingdom: The outlook brightens

Global Economic Outlook 2nd Quarter 2012

Figure 3. Consensus GDP growth forecasts for 2012

Source: Consensus forecasts from The Economist

Figure 4. UK private and public sector job growth (thousands)

400 300 200 100 0 -100 -200 -300

Private sector job growth Public sector job growth

Siddharth Ramalingam is an Assistant Manager at Deloitte Research, India

India: A delicate balance

Global Economic Outlook 2nd Quarter 2012

Global Economic Outlook 2nd Quarter 2012

Japan: New risk factors

by Dr. Ira Kalish

Global Economic Outlook 2nd Quarter 2012

Brazil: Worried about capital inflows

Global Economic Outlook 2nd Quarter 2012

Russia: Conflicting influences

Pralhad Burli is a Senior Analyst at Deloitte Research, India

Indonesia: Unlocking potential

Global Economic Outlook 2nd Quarter 2012

Dr. Satish Raghavendran is Vice President at Deloitte Research, India

Neha Jain is an Analyst at Deloitte Research, India

Trade patterns of the future: Waking up and smelling the coffee

Trade patterns of the future: Waking up and smelling the coffee

Global Economic Outlook 2nd Quarter 2012

Trade patterns of the future: Waking up and smelling the coffee

References and research sources: OECD, Going for Growth, 2012. 43

Global Economic Outlook 2nd Quarter 2012

GDP Growth Rates (YoY %)*

Ination Rates (YoY %)*

Ination Rates (YoY %)*